A Crash Course in Money Part VI

Dow up yesterday 159 points. Gold off $19. Santa Janet is busy in her workshop. Sugarplums are in investors’ eyes.

Back to our series…

Over the years, we’ve heard of dozens of different theories and practical approaches. From what we can tell, almost all of them work…sometimes. Then again, when you are investing in a market where prices have gone up 17 times (judged by the Dow Jones Industrial Index) over the last 32 years, almost any approach should show positive results.

The real test of an investment system is when prices go down over an extended time. And then…almost nothing works!

But our purpose in writing this series is to introduce you to the world of investing as we understand it (which is worth a warning in itself). There are a great many people far more technically proficient at investing. We are only interested in investing because we have to be. And we try to understand it in the simplest possible way…because we don’t want to spend much time on the practical details. Still, we’ve thought a lot about the theory behind it.

That was why the Efficient Market Hypothesis was so attractive. Theorists told us that there was no point in trying to time or beat the market, and that we were as likely to make money by throwing darts at a page of the Wall Street Journal as by doing painstaking analysis. We were happy to believe it; we like to throw darts.

How happy we were in those naïve, innocent days! But then we discovered the truth: hard work and discipline pay off when you are investing, just as they do almost everywhere else.

Still, one of the perversities of investing is that a little bit of work is probably worse than none at all. It turns out that throwing darts at a page of the Wall Street Journal is a better way to invest than what most people do.

How could that be? Simple. When you pay a little attention you become caught up in the fads and fashions of the investment world. The next thing you know, you are wearing the same thing other investors are wearing…and voicing the same opinions. That is when you will get the worst returns possible. You will buy too high and sell too late. You will be at the bottom of Wall Street’s food chain…a fat seal in a sea of sharks.

The evidence shows that it is hard for the typical investor to survive, let alone make financial progress. The averages mask the risk and the damage. This is because the market indexes take out the losers. Since 1980, 320 companies have been taken out of the S&P 500 because they were in distress. Two thirds of all the stocks in the Russell 3000 have underperformed the index and 40% of all stocks showed negative absolute returns over their lifetimes. And, again since 1980, four out of ten of the Russell 3000 stocks have suffered a permanent impairment of 70% or more from their peak value.

Even the pros find it hard to ‘beat the market.’ So far this year, 2014, the S&P 500 is up 12%. The average hedge fund is flat for the year. Over the last 6 years, the S&P rose 160%. And the super clever hedge funds? Up 41%.

What’s an investor to do? First, the evidence strongly suggests that stocks beat bonds over the long term. Over the past 100 years, investors in stocks have earned an average annual return of about 7%. Nothing else — cash, gold, real estate, or bonds — came close. Of course, as we pointed out yesterday, past performance is no indication of future performance. Most of the gains of the last hundred years came in the last 30 of those years. And those last 3 decades were marked, maybe even disfigured, by a colossal credit inflation that we are unlikely to see again.

So, let’s begin by going back to what we’ve learned so far. Most of your gains will come from allocation, not stock selection. The first question, therefore, is which market to be in. Let us take the evidence of the last 100 years — we don’t have much of an alternative; the best market to be in is the equity market. And let us now ask which equity market is the best one.

Until recently, there was no choice available. You had only to decide which sectors or which industries to be in. You didn’t have an opportunity to invest in foreign markets. Now it’s easy. You just buy an ETF or mutual fund.

But how do you select the market to be in?

Value, Value, More Value…Always Value

Of all the systems, tricks, and theories we’ve come across, the one that makes most sense and also seems to work is ‘value investing’. Not coincidentally, it’s the approach preached by a certain well-known investor from Omaha. He is an eloquent and influential proponent of the doctrine, but it is his wealth that is most persuasive. Using this investment system he has become, off and on, the richest man on earth.

The idea is very simple. A stock represents an ownership interest in a company. Its role in life is to render to its owners a share of the company’s earnings. To know what the share is worth, you simply calculate how much in earnings it will bring you. Then, you discount this stream of earnings to present value (obviously, a bird in the hand is worth more than two in the bush). Still, you are not quite finished. Because you know that the birds might fly away or die, you also want a ‘margin of safety’. That is, you should insist on paying less than you think the stock is really worth to protect yourself from error.

Once you have established what the stock is worth, you compare it to the current market price. If the market price is higher, you stay away (or sell, if you own the shares already). If it is lower, you consider buying.

Voilà. That’s all there is to it.

If you do your research carefully…and if you are disciplined and patient…you will still not necessarily make more money than other investors. But at least you’ll deserve to make more money, which is all we mortals can ever do.

Value investing applies to individual stocks. But the principle can be used to help with asset allocation decisions too. In fact, it happens naturally. As the stock market rises in prices, the value investor gradually sells his shares. He is squeezed out of the market — as Buffett himself was in 1968. Since we now have the option of investing in different markets, we can turn our gaze elsewhere. We can choose another market, where prices are not so high…and where the credit bubble has not inflated equity prices.

Much research has been done on the subject of value investing. The most well-known is that of Robert Shiller, a Nobel Prize winner, who developed a cyclically adjusted price earnings model (CAPE). This model tells us whether a market is expensive or cheap. Then, looking backwards, we can see what happened to stock prices going forward. Not surprisingly, he found what you would expect, that the more expensive a market became, the lower would be the expected capital gains over the following 10 years. Specifically, he found that US stock prices hit extremely high CAPE readings in 1901, 1928, 1966 and 1996. Each time, investors at these peaks had losses 10-20 years later.

The analysis was applied to 14 foreign markets. It found the same thing. When markets peaked out with CAPE readings over 32, the following returns averaged about zero over the next 15 years. You can imagine that the inverse is also true. When your CAPE readings are low, the following 15 years produce above-average rates of return.

We were so excited about this technique that we decided to do some research of our own. Our researcher — Stephen Jones — discovered weaknesses in the CAPE formula. He has corrected them and added adjustments for the two things that bear most heavily on whole economies — demography and debt. He calls his new model DAMA. We think it gives us a clearer and better way of finding the best place for equity investments.

Bill Bonner

Since founding Agora Inc. in 1979, Bill Bonner has found success and garnered camaraderie in numerous communities and industries. A man of many talents, his entrepreneurial savvy, unique writings, philanthropic undertakings, and preservationist activities have all been recognized and awarded by some of America's most respected authorities.

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